Seeking Alpha
, QVM Group (150 clicks)
Profile| Send Message|
( followers)  

Too many eggs in one basket runs the risk of breaking them all due to a single cause. That applies to asset classes, individual securities, investment themes or projections, and asset custodians.

The idea of diversification is well known and fairly widely practiced in most of these areas, but with respect to fund custodians, not so much.

Because of practical limitations on efforts to diversify investment fund custodian risk, an argument exists to utilize individual stock and bond holdings alongside ETFs and mutual funds in a portfolio. Individual securities (as opposed to funds) have broker custody risk, but not fund custodian risk -- two different potential points of entry to the financial system by cyber terrorists or governments engaging in cyberwar against us.

In a prior article titled "Risk Management Practices to Minimize Potential Cyberattack Damage to Your Investments", we discussed managing risks associated with cyberattack on the broker custodians of your assets.

In this follow-on article, we discuss managing the risks associated with cyberattack on the custodians of the assets of the investment funds in which you may have positions.

If you own and ETF or a mutual fund, whether it is held in street name for you or whether you hold the paper share certificate; the assets of that fund are held for it in a custodian bank. The records of that bank could be damaged, scrambled or deleted in a cyberattack.

Therefore, while potentially distorting investment choices and further adding to the research burden and general pain in the rear-end, you might want to be aware of the concentration of your investment fund assets held by individual custody banks.

We all have to hope that those custody banks are digitally safe, secure and redundant. At a minimum, they are probably well backed up. Unfortunately, these past few years have proven that in more cases than most us ever imagined, the emperor has no clothes.

You find out who the custodian bank is by either reading the prospectus or the statement of additional information; or by calling the investment fund customer service phone number provided on the fund website.

If you have two roughly equivalent fund choices with different custodian banks, you might want to consider choosing the one that is a better custodian bank risk diversifier than the other.

Given the limited number of custodians and the large number of funds, the difficulty in diversifying this risk is substantial. And, given the concentration of assets held by a limited number of custodians, we would assume that those who intend us harm may target that end of the business. That is partly why we suggest not having all assets in funds, but also some in individual securities too.

Here are some examples of custodians for some funds. None of these are recommendations pro or con. They are merely examples to show the diversity or lack of diversity in use of custodians by investment funds, should you choose to attempt to diversify that risk under cyberattack.

Total or Near-Total U.S. Stocks

  • IYY from iShares uses State Street Bank and Trust
  • VTI from Vanguard uses JP Morgan Chase Bank
  • SCHB from Schwab uses State Street Bank and Trust

U.S. Large Cap Stocks (S&P 500)

  • IVV from iShares uses State Street Bank and Trust
  • VFINX from Vanguard uses Brown Bothers Harriman
  • SPY from SPDR uses State Street Bank and Trust
  • FUSVX from Fidelity uses Bank of New York Mellon

U.S. Mid-Cap Stocks

  • IJH from iShares uses State Street Bank and Trust
  • VIMSX from Vanguard uses Brown Brothers Harriman
  • MDY from SPDR uses Bank of New York Mellon

U.S. Small-Cap Stocks

  • IWM from iShares uses State Street Bank and Trust
  • NAESX from Vanguard uses JP Morgan Chase Bank
  • SLY from SPDR uses State Street Bank and Trust

U.S. Equity REITs

  • IYR from iShares uses State Street Bank and Trust
  • VNQ from Vanguard uses Brown Brothers Harriman
  • RWR from SPDR uses State Street Bank and Trust

Emerging Market Stocks

  • EEM from iShares uses State Street Bank and Trust
  • VWO from Vanguard uses Brown Brothers Harriman
  • GMM from SPDR uses State Street Bank and Trust
  • SCHE from Schwab uses State Street Bank and Trust

U.S. Dividend Stocks

  • DVY from iShares uses State Street Bank and Trust
  • HDV from iShares uses State Street Bank and Trust
  • VYM from Vanguard uses Bank of New York Mellon
  • SDY from SPDR uses State Street Bank and Trust
  • HYD from Market Vectors uses Bank of New York Mellon
  • FDL from First Trust uses Bank of New York Mellon
  • PEY from Powershares uses Bank of New York Mellon
  • DHS from Wisdom Tree uses Bank of New York Mellon

U.S. Aggregate Bonds

  • AGG from iShares uses State Street Bank and Trust
  • BND from Vanguard uses JP Morgan Chase Bank
  • LAG from SPDR uses State Street Bank and Trust
  • FBIDX uses Bank of New York Mellon

Specialized Funds

  • PTTRX from PIMCO uses State Street Bank and Trust
  • GRPC from Russell Investments uses State Street Bank and Trust
  • FXE from Currency Shares uses JP Morgan Chase Bank
  • MERFX (merger arbitrage) uses US Bank
  • ARBNX (merger arbitrage) uses State Street Bank and Trust
  • BSJF (target date bonds) from Guggenheim uses Bank of NY Mellon

Futures-Based ETFs

  • DGL (gold) from Powershares uses Deutsche Bank (commodity sub)
  • DBO (oil) from Powershares uses Deutschse Bank (commodity sub)
  • USO (oil) from US Oil Fund uses United States Commodity Funds
  • UUP (dollar idx) from Powershares uses Deutsche Bank (commodity sub)

Gold ETFs (physical custody requires knowledge of location as well)

  • GLD from SPDR uses HSBC bank (London)
  • IAU from iShares uses JP Morgan (London)
  • SGOL from ETFS uses JP Morgan (and UBS as Zurich sub-custodian)
  • AGOL from ETFS uses JP Morgan (Singapore)

We have limited amounts of gold exposure in our accounts at this time, but given the physical risk issues (fraud, theft, mysterious disappearance, fake gold deposits, and civil war or chaos that may result in pilfering), we would tend to use multiple gold funds to achieve geographic diversity in those holdings.

Disclosure: QVM has long positions in GLD in some accounts as of the creation date of this article (January 2, 2012).

Disclaimer: This article provides opinions and information, but does not contain recommendations or personal investment advice to any specific person for any particular purpose. Do your own research or obtain suitable personal advice. You are responsible for your own investment decisions. This article is presented subject to our full disclaimer found on the QVM site available here.

Source: Consider Diversifying Fund Custodian Risk In The Event Of Cyberattack