Caveat emptor – ETFs are best left to the professionals

Exchange traded funds (ETFs) are rapidly becoming the ‘must-have’ component of an investor’s portfolio. At the end of June, assets in ETFs hit a record high of $3.2 trillion globally according to data from research consultancy ETFGI and demand shows no signs of abating. Popular with both institutional and retail investors, ETFs are increasingly marketed to the latter with a focus on their transparency, liquidity and low cost base. Robo advisers’ solutions-based investment offerings are in many cases based on ETFs. On the face of it therefore, ETFs are a simple way to gain exposure to a broad range of markets and assets with low expenses and good liquidity. But I believe the reality is somewhat different and worryingly something that many retail investors are unaware of.

ETFs appear to provide a good solution to investor demand for ‘certainty’ and ‘safety’ in their portfolios. But rather like a dormant volcano, the risks tend to rumble under the surface ready to erupt at any time. A foretaste was experienced in late August 2015 following a sharp drop in equity markets around the world. Many markets fell around 5% in just one hour of trading but certain ETFs, including those tracking the same market indices, fell by up to 40%. The underlying risk of ETFs when markets suffer excessive volatility was clearly highlighted. Many ETFs behaved in an unpredictable and volatile manner and, as an asset class, experienced greater increases in volume and more severe volatility than corporate stocks. Retail investors in ETFs learnt a painful lesson during this episode.

Even in a stable market, though, the simplest replicating ETFs may not meet with the expectations of long-term investors. Ostensibly they are designed to deliver a return which closely matches that of the index they replicate and, while the difference in returns may be negligible over short timeframes, longer-term investor experience could differ quite significantly as the plot below of cumulative returns for the FTSE 100 Index and iShares FTSE 100 ETF illustrates. While a fall of 10% over 15 years may not be a disaster, the very fact that it occurs at all is contrary to the expectation of the investors holding it in their portfolios. Moreover, holdings in active funds and individual shares, although carrying greater downside risk, allow for significantly more upside potential.

The fundamental appeal of ETFs is to asset allocators, professional investors and traders, something which I believe is somewhat at odds with their apparent suitability for long-term retail investors. For example, there is substantial volume of high frequency trading of ETFs by professional investors such as computer-driven trading firms which has a major impact on the price. There are also leveraged ETFs that invest with borrowed money, but these in general should not be seen as suitable for the retail investor, nor for the long-term portfolio. Leveraged ETFs carry a higher level of risk. For example, while they may outperform the traditional index in a rising market, they may underperform more on the downside. They may also be less liquid and carry higher fees. Moreover, other than back testing, there is no track record of how these products perform in a severe down market.

There are also signs that easy access to ETFs is changing the behaviour of investors. A study in Germany[1] found that the use of ETFs in portfolios encouraged short-term trading and increased attempts to ‘time the market’. Ultimately this led to worse performance over the long term than in portfolios not using ETFs or index products.

The latest trend in the ETF world is the growth of ‘smart beta’ ETFs. These emerged after the financial crisis and have quickly become the product du jour. Smart beta ETFs aim to provide superior risk-adjusted performance by being a hybrid – part index and part actively managed. Usually, the products track an index using a variety of screens to reconfigure the underlying index. They aim to earn more return with less risk than a traditional product, for example, offering lower volatility or alpha over the market-cap equivalent. Smart beta ETFs are particularly popular in ‘solutions’ offerings such as income generators or dividend-focused strategies. However, they could concentrate an investor on a single sector or style which may carry more tail risk than expected or they may carry the risk of a build-up in exposure to undesirable factors as a side-effect of the construction process. For example, a Minimum Volatility ETF, which in the current prolonged risk-averse environment may have picked up exposure to momentum and be invested heavily in stocks that trade on extremely rich valuation multiples, could see future performance be increasingly less contingent on the original alpha factor(s) that it was designed to harvest.

With the popularity of ETFs in all their forms, the danger is that they become one huge crowded trade (you could argue that smart beta trades are already in crowded territory). The extensive range of ETF strategies provides an important asset allocation and trading tool and there is clearly a place for them in the professional portfolio. But I believe the danger is that retail investors can be lulled into a false sense of security by the apparent simplistic nature of ETFs. Many are high risk and complex, unsuited to a long-term portfolio and could result in unexpected volatility and losses.

[1]The Dark Side of ETFs and Index Funds. Utpal Bhattacharya, Benjamin Loos, Steffen Meyer, Andreas Hackethal and Simon Kaesler  March 2013

The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.