The Risks of Synthetic Tracking Funds

The debate between physical and synthetic tracking has become heated in recent years and many investors in the UK have what can seem like an irrational distrust of synthetic ETFs. Pros and cons exist for both forms of tracking: you simply need to understand the risks and make a considered judgement. To help you weigh up whether ETFs are for you, check out this table.

Advantages and Disadvantages of ETFs
Advantages Disadvantages
Cheap Substantial trading costs: that is, dealing charges and bid-offer spread (the latter can be over 1 per cent)
Liquid and easy to trade – continuous pricing during the day Can trade at a discount or premium to net asset value, which can eat into your gains if you buy at a premium, for example, that disappears by the time you’re ready to sell
Can be shorted and leveraged to increase returns Short track record of many funds, making it difficult to evaluate whether the fund has been historically successful
Huge choice and access to a wide range of indices; that is, you can diversify broadly Unsuccessful ETFs can quickly shut down
Ability to invest in a whole market through one fund Not all ETFs are that cheap – some specialist ETFs charge close to 1 per cent, which is still much lower than most ordinary mutual funds
A tracking error can emerge; that is, a difference between the change in the value of the fund and that of the index

High tracking errors in physical replication tracking ETFs

For physical tracking funds, the most obvious risk is the tracking error. When the ETF manager holds the basket of shares (or assets) that comprises the asset, notice that he doesn’t promise to pay the actual return on the underlying index! He merely promises to try to track the index and sometimes a discrepancy opens up between the fund return and the index return. Most listed funds such as ETFs manage to keep that tracking error to the absolute minimum, but be aware that some listed funds and many unit-trust index trackers produce hefty errors amounting to more than 1 per cent or even 2 per cent per year.

You also need to keep a beady eye on dividend payments and how they affect tracking errors. An ETF typically pays out dividends received from the underlying shares it holds on a quarterly basis, but the underlying stocks pay dividends throughout the quarter. Therefore, these funds may hold cash – cash that could be better deployed in an actual investment, making you a potential capital gain – for various time periods throughout the quarter, even though the underlying benchmark index isn’t composed of cash.

Market risks affecting the ETF’s sector

Another factor to watch out for is market risk – that the sector or market the ETF is tracking drops based on a variety of factors such as economic conditions and global events, investor sentiment and sector-specific factors. In a big sell-off, investors typically sell all shares regardless of structure – and so, being very liquid, ETFs can suffer disproportionately. When panicking, investors are likely to sell first an ETF share they can get rid of in real time via their broker instead of a unit-trust fund for which they have to wait to the end of the day to establish a proper pricing level.

‘Hidden’ costs in expensive or exotic ETFs

You also need to be careful of expensive ETFs and even more exotic indices. The reality is that not all ETFs are created equal. Market-leading ETFs may quote wonderfully low expense ratios in their blurb, but a more detailed analysis of the market may reveal huge variations in costs.

A study by the US-based American Association of Individual Investors (AAII) identified expense ratios for 281 of the 299 funds in the US market in 2006. Of these 281 funds, 35 had an expense ratio of between 0–0.22 per cent; 130, 0.21–0.5 per cent; and 96, 0.51–0.75 per cent. More alarmingly, 14 funds had expense ratios above 0.75 per cent – which is an awfully high charge for what should be a simple exercise in tracking a major market.

Risks associated with stocklending

If you invest in a physical tracker you can probably be confident that your counterparty risk is very low; after all, your fund manager owns the big basket of shares you’re tracking. But you do need to be aware of a risk based around the activity of stocklending. Those physical baskets of liquid assets represent a real opportunity for ETF specialists (such as, in this section, iShares), and stocklending is when they lend out the share and bond certificates for limited periods of time to external organisations who want to borrow them.

The borrowers are likely to be hedge funds or bank-trading desks with a particular view on a company (bearish or bullish) and want to make a quick profit by speculating on stocks and bonds they don’t own. The borrower of stocks and bonds in an iShares ETF portfolio obviously has to pay a fee for the duration of the loan. It also lodges collateral, which in nearly all cases amounts to more than 100 per cent of the value of the loan and, in some isolated cases, can amount to as much as 145 per cent of the value of the loan.

iShares openly discloses on its websites how it manages the stocklending programme. For instance, its FTSE 250 ETF at the beginning of December 2011 lent out 91 per cent of its shares by value of the fund.

iShare’s investors can also download a spreadsheet that shows the collateral it receives in return – Table 16-4 shows the collateral offered up by borrowers using shares from the FTSE 100 index. In December 2012 that collateral in the FTSE 100 tracker included shares in American tobacco group Philip Morris, giant consulting group Accenture and asset manager Invesco.

As you can see, average collateralisation is about 112 per cent of the value of the shares loaned. In addition, fund custodians want some diversified risk for lending out more speculative FTSE 100 large-cap stocks. In return, over the last year, the fund earned 0.01 per cent in fees, 60 per cent of which finds its way back into the fund via a lower total expense ratio (TER).

Stocklending Activity for iShares FTSE 100 ETF (at 15 December 2012)
Security Name Security Country Security Weight (%)
Philip Morris International United States 9.692
Accenture PLC – CL A United States 7.331
Mastercard Inc – Class A United States 6.873
Invesco Ltd United States 5.314
Stanley Black & Decker Inc United States 4.006

The risk with stocklending is that, if markets freeze up and borrowers start a scramble for liquidity, passive fund managers (those who invest according to a predetermined strategy) operating extensive stocklending programmes can find themselves in trouble, not least in liquidity terms as they try to unwind their collateral portfolios.

But outfits such as iShares are very careful about the collateral they accept in return for lending out their fund portfolios, and in many cases they make a deliberate effort to over-collateralise the risk exposure.

The extreme concern is that volatile markets impact massively on the value of that collateral. Stocklending is monitored on a daily basis but sudden moves in value can happen so quickly that the fund custodians are unable to adjust the collateral backing fully, leaving investors in the fund potentially losing all their capital.

ETFs that track indices that nobody uses

Remember to be wary about the index that’s being tracked. As competition intensifies in the ETP sector generally and in ETFs specifically, more suppliers are turning to highly specialised indices, which is no problem unless disreputable indices end up emerging.

In recent years, for instance, research firms have launched all manner of complex indices that track hedge-fund strategies – clever stuff perhaps, but not really the same as tracking the bog standard FTSE 100. If you aren’t careful you can end up tracking an index no one uses or cares about or that has no real economic value.

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