ETFs Structure And Practice: Potential Issues Or Popular Myths?

Brandes Investment Partners

December 2012

Brandes Institute Research Paper No. 2012-06

Abstract:

At first glance, exchange-traded funds (ETFs) may seem like ideal investments. Benefits including low cost, flexibility and tax advantages make them viable choices for many investors and have helped assets in ETFs grow substantially in the past 10 years. While some ETFs could be suitable investments in many situations, aspects of their structure and how they are being used may be creating potential risks.

This article combines excerpts of select, existing studies and comments from industry experts to debunk certain myths about the dangers of ETF investing and to highlight possible issues for individual and institutional ETF investors, especially issues related to liquidity, securities lending and short interest. We seek to provide the basis for measured questions that thoughtful ETF investors may pose regarding investments already made, or being considered.

Throughout this piece, we refer to ETFs for simplicity, but the issues addressed also could be applied to most exchange-traded products (ETPs) such as exchange-traded notes (ETNs) or exchange-traded certificates, currencies and commodities (ETCs).

ETF Structure And Practice: Potential Issues Or Popular Myths? – Introduction

Focusing on the benefits of ETFs, including low cost, tax advantages and ease of trading, investors may believe that ETFs are ideal. In many cases, that may be true. But there are potential issues thoughtful investors may wish to investigate and a number of reasons to perhaps stick with traditional funds or separate accounts:

UNDERPERFORMANCE. As with almost any passive investment, ETFs lock in underperformance. Returns for ETFs rarely exceed those of the benchmarks they seek to replicate. Even though ETFs tend to have very low costs, their structure makes it difficult for them to outperform.
COSTS. Oft en touted for their low expense, “the range of the ETP (exchange-traded products) universe spans nearly 200 basis points from products that cost as little as fi ve basis points to those charging close to 2.0%.”1 Investors should investigate expenses—and not simply assume every ETF offers an ultra low-cost strategy.2
COMMISSIONS. Financial Advisor magazine reports that “hundreds of exchange-traded products are eligible for commission-free trading across a number of diff erent platforms.”1 At the same time, many investors who actively trade ETFs pay a commission for each purchase and sale. Th is should be less of an issue for long-term investors, but we share the opinion of John Bogle, founder of passive investment leader Vanguard, who said, “There’s no question that ETFs are the greatest trading innovation of the 21st century. But the question is, ‘Are they the greatest investment innovation?’ and the answer is ‘no.’” Bogle recalled seeing an advertisement for the SPDR S&P 500 ETF that offered the ability to trade it throughout the day and wondered, “Who the hell wants to do that?”
SPREADS. While most ETFs have very narrow spreads (the difference in the price paid to purchase shares and the price received when selling), some ETFs have wide spreads. Similar to buying and selling less-liquid stocks, a wide spread represents a built-in drag on returns that can be compounded with frequent trading.
SAMPLING. A number of commonly traded ETFs use a technique called representative sampling to generate holdings; the ETF does not hold all the holdings in the index it tracks, or it holds them in different weights to accommodate large assets under management. ETFs using this sampling technique tend to bias security selection toward larger or more liquid index constituents. Th is may result in tracking error and under/over exposure to segments of the index.
RESET FOR LEVERED ETFs. For investors considering levered ETFs that off er two or three times the returns of an index, they should note the different ways in which that leverage is reset: daily, monthly or longer. Some ETFs are designed to be bought and sold within the same day. If they’re held more than a day, returns will not match the ETF stated price change as the ETF resets its levered positions daily. At the other extreme, some may not reset for a decade, meaning that “…effective leverage realized when establishing a position can be very different from the initial target–sometimes as much as eight times.”4
ACTIVE MANAGEMENT. Th e notion that passive investing has outperformed active management has gained supporters in recent years. But there are big differences among active managers. These differences can be illustrated by a tool such as “active share.” “Active share is the portion of a manager’s portfolio that is different than the manager’s underlying benchmark. It is calculated by summing a manager’s overweights and underweights and dividing by two.”5 Th is tool may be used to discern truly active managers from those whose portfolios closely resemble an index, but charge active management fees. Studies have shown that truly active managers have a greater potential to outperform.5
COMPLEXITY. As shown in Exhibit 1, there are more than 1,100 ETFs available for U.S. investors. “If you’re looking to build a long-term, buy-and-hold portfolio, the vast majority of them are not appropriate for you. Included in the ETF lineup are a number of very sophisticated, very risky securities. If used correctly, they can be very powerful tools. But if used incorrectly—or by investors who don’t fully understand their mechanics—the results can be disastrous,” according to Financial Advisor magazine.

Aft er the 2008-9 financial crisis, sellers of relatively new financial instruments were asked if they really understood the inherent risks. Some are asking similar questions now about ETFs. Are they truly the answer to some investors’ needs? Or are there some hidden risks in the way ETFs are constructed that should make investors cautious?

Th is remains a vigorous debate in the industry, and the body of this paper examines several sources of potential risk, asking which are based in fact, which in myth. Our goal is to provide guidance on unseen or poorly understood risks that may be embedded within the ETF structure. We encourage all investors to ask questions about the ETFs they are considering, paying special attention to the following:

Liquidity
Securities Lending
Short Interest
Failed Trades
Synthetic ETFs

Ultimately, investors can decide for themselves if certain ETF risks are material. Our view is that it’s better to proceed with information, rather than working with assumptions alone.

Background

At a Brandes Institute Advisory Board meeting, we invited Harold Bradley and Som Seif to share their perspectives on various ETF issues. Aft er that meeting we interviewed other ETF experts and read various studies on aspects of ETF structure, custody and trading.

Bradley was the Chief Investment Offi cer for the Ewing Marion Kauff man Foundation, the largest foundation in the United States focused on entrepreneurship and fostering the growth of capital markets. Bradley has been critical of aspects of ETFs, co-writing white papers7 on the topic with former colleague Robert Litan, and sharing his concerns in testimony before the U.S. Senate Subcommittee on Securities, Insurance and Investments in October 2011.

Seif founded Claymore Investments in 2005. His company grew to be the second-largest ETF provider in Canada before being sold to BlackRock in the first quarter of 2012. Seif left the fi rm in mid-April 2012. While very supportive of ETFs, Seif said investors need to do their homework, “Th ere are pros and cons to the ETF structure that are very important for today’s investor. Th ere are absolutely troubling facts and issues that are going on within the ETF industry—areas where investors need to be more focused.”

The first ETFs were designed to replicate an index and provide investors with a low-cost, simple method for owning all the securities in that index. With one trade in the SPDR S&P 500 (NYSE:SPY), for example, an investor could establish a stake in the companies that make up the S&P 500 Index. ETF offerings have evolved quite a bit since their introduction and now include funds designed to replicate much narrower segments of the market (stocks within an industry) or deliver two times or three times the returns in an index (leveraged ETFs).