Funds' proliferation means choice, but also more risk, writes Andrew Gawith, director of Gareth Morgan Investments.
In a world where there is nothing new in terms of principles of effective and efficient portfolio management, it is bemusing to see the plethora of new vehicles and products being launched by an industry focused on exciting investor interest and appealing to the latest in investor sentiment.
The previously staid world of Exchange Traded Funds (ETFs) is no exception.
The ETF industry began simply enough in the United States in 1993 with the launch of the SPDR (commonly called Spyder), a fund that tracks the movements in the S&P 500 Index.
Early ETFs were designed to deliver returns similar to broad-based sharemarket indices and to give liquidity to more active traders. They were also low-cost and transparent. An investor knew exactly what was in the fund as the manager of the ETF had to go out and purchase the physical stocks of the index they were tracking.
It's been an explosive period of growth for the industry globally. The ETF industry was still relatively small at the start of the decade with roughly US$40 billion ($59 billion), but now there is more than US$1 trillion invested in ETFs.
ETFs have even made it to capital markets of Australasia. The market capitalisation of Australian ETFs has more than doubled in the past year to A$3.4 billion ($4.2 billion) although the New Zealand market is a more paltry $65 million.
The proliferation of funds that has accompanied the growth in assets can be a quagmire for the poor old investor trying to sift through it. What started out as a relatively simple and transparent suite of ETFs has become an increasingly complex and bewildering array.
ETFs have expanded beyond replication of large and liquid equity indices to a wide range of thematic indices. They now encompass asset classes as varied as bonds, commodities and currency markets.
Undoubtedly there is now more choice, which ought to be a good thing, but in some instances investors might not always be getting what they think they've got.
It's a reasonable assumption to think that an ETF should deliver the performance of the specific index it is designed to replicate. In practice that is not always the case.
Take leveraged funds, which have been a popular area of growth recently. If you buy a two-times leveraged ETF you might expect your portfolio to double. If the market is up 5 per cent then your fund should be up by roughly 10 per cent.
But the way these funds track the underlying index and the effect of daily compounding and volatility mean you could end up with a return that is far less than the market's movement of 5 per cent. While these ETFs will do what they say on a daily basis they do not do this over longer time periods.
Performance in some of the commodity ETFs can also fall a long way below that of the underlying spot price of the commodity it is attempting to track. A large number (though not all) of commodity funds invest in futures contracts that get rolled over before they expire. These ETFs frequently have to deal with the problem of contango; that is, their returns fall short of the index when futures' prices are above spot prices - that's commonly the case.
It's not just trying to keep ETF returns in line with their respective indices that might be of concern to investors. As ETFs have stepped into markets that are more niche and less liquid and easy to trade, the use of derivatives has grown. Some funds can be entirely synthetic.
This is introducing an increased element of counterparty risk. Who is the party on the other side of these transactions? If they go bust the fund might not get its money back. Risks like this can always be reduced by the manager through the use of multiple counterparties and good collateral monitoring, but there are no set rules as to how this should be done and in a lot of ETFs it is difficult to know exactly what is going on.
As more ETF providers enter what is becoming a fairly crowded market, it's likely we will see an increasing number of niche-style [products], and more expensive products emerging.
ETFs are a useful addition to the investment world but may not be all they are cracked up to be. Investors need to understand what they are getting into. The core concept is fine but new entrants are in danger of corrupting that concept and delivering high-risk, higher fee options for the gullible.
