How to see the hidden risks of ETFs

February 22, 2018

4 minute read

by Sloane Ortel, Paul Kovarsky, CFA and Antonella Puca, CFA, CIPM, CFA Institute

Exchange-traded funds (ETFs) attracted more flows than “any structure ever” in 2017, according to Bloomberg’s Eric Balchunas.

Is that bad? Steven Bregman, CFA, of Horizon Kinetics says the herd behavior ETFs inspire will be the “Delivery Agent of the Great Bubble.” Mohamed El-Erian believes that the instruments “over-promote” the liquidity of their underlying securities, which is in line with findings from BlackRock in 2015 that fixed-income ETFs trade much more often than the bonds that comprise them.

Such sins, both real and imagined, mean ETFs are now described as “weapons of mass destruction” with disconcerting regularity. Mark Weidman, the global head of iShares, has said “ETF apocalypse concerns are way overdone” at least once. And yet the murmurs continue.

There is no doubt ETFs are weird, but managing the risks they pose on behalf of clients doesn’t require a high-definition vision of the future. It just takes a simple question:

What can’t the client see?

ETFs are a great way to fulfill client objectives, but they also create a handful of opportunities to miss the mark. So advisers need to be vigilant.

A primary risk is that the fund will fail to appropriately track its benchmark. This can happen because of market conditions, despite the best intentions of the fund sponsors. So rather than adopting a “set it and forget it” mindset, advisers need to be diligent and monitor the ETFs in which they invest.

A straightforward example of this comes from the world of high-yield ETFs. Lisa Abramowicz noted this summer that the SPDR Bloomberg Barclays High Yield Bond ETF, trading under the ticker JNK, underperformed its benchmark by an average of 1.69% for the three years preceding her 18 August 2017 column. Rival fund BlackRock’s iShares iBoxx USD High Yield Corporate Bond ETF (HYG)’s three-year average underperformance of 0.79% seems like alpha by comparison.

It’s understandable that there would be a difference between the performance of an index and the vehicles designed to track it. Even when their objective is just to replicate an index, investment vehicles come with costs that are not always explicit. A 2013 exploration of these issues from Morningstar found that funds generally did a good job limiting tracking error, but also pointed to interesting issues. The weekly error for ETFs tracking the MSCI Emerging Markets Index, for instance, ranged from 0.04% to 1.5%.

A Defining Challenge

If the performance of ETFs that track specific indices can be that variable, what about the funds with more idiosyncratic objectives?

Take the iShares MSCI BRIC ETF (BKF) and the Guggenheim BRIC ETF (EEB) as cases in point. Both seek to provide diversified exposure to Brazil, Russia, India, and China, but how much of each? The iShares offering had 61.5% invested in China and 7% in Russia at the time of this writing, while Guggenheim’s fund had 20.2% in China, 13.9% in Hong Kong, and 18.1% in Russia.

You would think targeting just four countries would make the innate challenge of defining emerging markets simpler, but that’s just not the case. Fund structures can only mask the intrinsic complexity of markets, not eliminate it.

A vignette about ExxonMobil that Bregman offered to Grant’s Interest Rate Observer illustrates this well:

“Aside from being 25% of the iShares U.S. Energy ETF, 22% of the Vanguard Energy ETF, and so forth, Exxon is simultaneously a Dividend Growth stock and a Deep Value stock. It is in the USA Quality Factor ETF and in the Weak Dollar U.S. Equity ETF. Get this: It’s both a Momentum Tilt stock and a Low Volatility stock. It sounds like a vaudeville act.”

It may be the case that 138 years after John D. Rockefeller et al. formed the Standard Oil Company of Ohio, the shares of its corporate successor are indeed a tidy fit for such a broad diversity of investment objectives. But if that’s true, it also means that the risk of confusing activity and progress in managing ETF portfolios is real.

Ask the Right Questions

Determined curiosity is the primary asset you have to address these risks. A Comprehensive Guide to Exchange-Traded Funds (ETFs) is likely to be helpful, but there is no substitute for your own analysis.

So ask questions. How liquid is this fund compared to the securities that compose it? Does it trade at a premium or a discount to its net asset value? Is there leverage built into the structure, and if so, is that leverage constant or variable? How closely does it track its benchmark?

But don’t forget the most important question: Does this asset fulfill a useful purpose in this portfolio? The recent wave of ETF offerings comes with a substantial risk of distraction: Diligencing structures are not necessarily indicative of progress towards fulfilling an investment objective.

It is critical to advance the state of practice in this area, and that’s why we will be joining industry leaders at the Inside ETFs Conference next week to listen, learn, and teach. What’s clear already is that most practitioners have plenty to learn about the structures that will likely continue to grow in prominence for the rest of our careers.

As cutting edge becomes commonplace, we’re hopeful that discussion will turn away from apocalyptic predictions and towards the mechanics of diligence.