On 11th January I published my first annual letter to the holders of the Fundsmith Equity Fund. In it I levelled some criticisms at the investment fad for Exchange Traded Funds ("ETFs").
One of my basic concerns was that I thought there was a danger of ETFs being mis-sold. I suspect a lot of retail investors think that ETFs are the same as index funds. Some of them are, but many aren't. In particular, the performance of short ETFs and leveraged ETFs may diverge markedly from what an investor who believes they are simply index funds would expect. It isn't hard to give examples in which investors would lose money on a leveraged long ETF if the market went up over a period of significant volatility, or in which they lost money owning a short ETF and the market went down over a period in which there were some sharp rallies. The problem is with the daily compounding of ETFs.
Plus many ETFs do not contain a basket of the underlying securities or assets which they are attempting to track. Instead they hold asset swap agreements with a counterparty (often the bank which is the ETF sponsor) which aim to replicate the performance of the index or asset concerned. There are obvious dangers in such an arrangement in the areas of counterparty risk and collateralisation of the sort which caused so many problems during the Credit Crisis.
A good example of the potential risks here is given by PEK, the NYSE listed Market Vectors China A Shares ETF. It is illegal for foreign investors other than licensed institutions to buy A Shares listed in Shanghai or Shenzhen. So the ETF owns swaps with brokers who are licensed to hold the underlying shares. If PEK owned a significant portion of the float in A Shares and its holders tried to liquidate at speed it might be interesting.
Some commentators claim we need not worry much about retail investors misunderstanding ETFs as in Europe at least, they are mainly utilised by institutional investors. This of course misses a couple of vital points. One is that the underlying clients for many of those "institutions" are individual investors - do they really understand the risks their private wealth manager is running with ETFs? Also the Financial Times FTfm supplement carried an article on 9th May pointing out this lack of direct retail involvement in ETFs in Europe on the same day as the wrap around advert for its supplement was supplied by Amundi ETF. On that day commuters coming into London were being given handouts of glossy brochures on Amundi ETFs plus a natty plastic credit card/season ticket wallet emblazoned with the slogan
"Amundi ETF More than just another tracker"
At this rate we may soon have to worry about the direct retail involvement in ETFs.
However, there is another and perhaps more pernicious danger with ETFs than misunderstanding or mis-selling. An ETF is in effect a hybrid vehicle which combines features of an open-ended or mutual fund with those of a closed-end fund. They are like open-ended funds insofar as a purchaser buys or redeems so-called creation units. But they are also tradable in the secondary market, so ostensibly providing real time liquidity.
Secondary trading activity brings with it the possibility that market participants will short the ETFs themselves. And there is no limit to the short selling, which is possible in an ETF, in the same way that there is in an equity. In an ordinary equity, the short-selling is limited by the ability of the short sellers to borrow the stock so that they can deliver it to complete their sell bargains. In an ETF a short seller can always rely on the process of creating shares in the ETF to ensure he can deliver.
This leads to the possibility that a buyer of an ETF share is buying from a short seller and that no new share has yet been created. The investors who buy from the short sellers don't own a claim on the underlying basket of securities or swap in the ETF, they own a promise to deliver the ETF share given by the short-seller.
The problem this causes is that as no new shares are created in the ETF by this process, the assets of the ETF may become significantly less than the outstanding cumulative buy orders would suggest. This is a significant problem given reports that there has been short-selling up to levels of 1000% short in some ETFs.
You might think that one way to overcome the risks involved in this at a stroke is for the ETF sponsor to create the shares represented by the cumulative buying interest, but this may be easier said than done. Take an ETF like IWM in which the short interest recently exceeded 100% or $15bn. IWM invests in the Russell 2000 US small cap index. To invest $15bn in the basket of stocks involved would require about a week's trading and that is if the ETF creation was the sole trading in those stocks. The scope for a short squeeze is tremendous.
The net result is that across the entire ETF asset class portion of the funds which ETF purchasers think have been invested in ETFs, via the creation of new shares, has in effect been lent to hedge funds. The ETF holdings are not all backed by assets of the sort investors expect, even if they understand what the ETF is meant to do.
Perhaps these little understood structural issues explain why 70% of the cancelled trades in last May's Flash Crash were in ETFs when ETFs represent only 11% of the securities in issue in the US.
Moreover, in the case of some ETFs such as PEK it is difficult to fathom what the short interest in PEK really represents as it is illegal to short China A shares.
Another example of the issues in this sector which recently crossed my desk was a fund raising proposition for a business which undertakes trading in ETFs. It shall of course remain nameless, but it trades, arbitrages and makes prices in ETFs with a particular focus on the less traded ETFs. This company describes itself as a 'fairly thinly capitalised entity'. There are echoes of the parallel banking system in the Credit Crisis here. It also describes the pace of development in the ETF area as 'breakneck'. I just wonder whose neck will eventually get broken.