Progress indeed... but understand the risks

David Stevenson shares his thoughts on recent innovations in the index-tracking ETF space and asks are investors looking before they leap?

Spring is in the air and life is returning to the fastest-growing segment of the asset management industry - the index-tracking ETF space. 

Over the next few election-filled weeks, advisers should expect to see a continuing stream of fund launches and new arrivals to the market.

We have recently seen our first two times leveraged ETFs on mainstream equities, courtesy of stalwart Deutsche Db x-trackers. Source, a relatively new player, has also just launched an innovative range of European Stoxx sector ETFs that focus on strategies such as tracking cyclicals, defensives and consumer staples. Both of these funds will be welcomed by many sophisticated investors, with the usual caveats around the use of strategies and daily leveraged returns.

The arrival of whole product families from new providers will be less welcome to a market already showing signs of marketing fatigue, confusion and over-supply; there are currently no less than 55 different Eurostoxx 50 ETFs.

We will also be experiencing the innovative delights of equity dividend and currency specialist Wisdom Tree, whose CEO told me he also intends to launch some of his range later this year.

iShares will also no doubt be terrifically enthused to learn that its former sibling iPath, operated by former parent Barclays Capital is to launch a range of commodity ETCs in the next few weeks. Behold the impending carnage!

New default

Index-tracking exchange traded products may be the future default choice for most advisers post Retail Distribution Review, if only because of their lower cost and headline simplicity. But the closer you look at these innovative and welcome structures, the more they begin to resemble the mind-bending complexity of the Tardis.

They are simpler to understand and the headline total expense ratios (TER) are usually much lower, but investors need to be careful in analysing slightly curious practices such as stock lending for instance. On paper this is a good idea; an index-tracking portfolio manager with a basket of stocks rents them out to other institutions that might want the basket for hedging purposes. For this potentially profitable privilege, the stock lender/fund manager charges a fee, which can amount to more basis points than charged in expenses to the end investor.

It is obviously a hugely lucrative practice and many operators such as Vanguard hand all the returns back into the fund, but major players like iShares only split the proceeds 50/50 with their investors.

One can only guess at the total value of this practice – when iShares was auctioned the first-stage tender excluded the stock lending business but by the second round it had been included again, with the asking price for the business going up by millions.

The total cost of trading can far exceed the oft-touted TER, yet in hugely liquid markets such as the FTSE 100 the cost of liquidity can be as little as four basis points. Try and buy the underlying individual stocks in a basket and the actual cost would be closer to eight basis points. 

By contrast, poor liquidity can be a huge problem with less liquid, more inefficient markets, with bid offer spreads in the hundreds of basis points. Those wide spreads can also depend on the time of day – you are better off trading many commodity ETFs later in the day because of underlying market opening hours and liquidity declines for emerging market ETFs at exactly the same time each day. Add in tracking error and you have a potentially toxic outcome. A 2009 study by US investment bank JP Morgan found in the more mature US market tracking errors for mainstream physically replicated ETFs could exceed 100 basis points a year and over 400 basis points for some emerging markets stocks. This will all get worse – increased choice is great on paper but market makers have to build systems to cope with 55 different Eurostoxx 50 ETFs creating extra expense, which will be passed on through bid offer spreads and liquidity.

None of these issues should of course cloud our wider view of ETFs. As Christopher Aldous from Evercore Pan-Asset points out, once difficult to access asset classes have suddenly been opened up to all by ETFs, cost effectively and with relative transparency. According to Aldous if he had to buy a basket of corporate bond ETFs he would end up paying six to eight percent in transaction costs; yet the iShares fund has a TER of less than 40 basis points and a bid offer spread that is rarely above two percent.