Safety tips for synthetic ETF use

Losing money is the fundamental risk for anyone buying any financial product. Whether a stock, bond, mutual fund, or ETF, investors have an expectation that information about these products will be correct, timely and complete. An entire industry has grown up around compliance and disclosure. Regulations for marketing and advertising investment products seem more rigorous than for lottery tickets that have a significantly lower expected return than most investment products and whose buyers appear less likely to afford losses. Go figure. Lotteries in Ontario alone account for about $3.8 billion in annual revenue with about half going to the government. I “Googled” tax on the stupid and “lottery” popped up. What then should we make of the higher regulatory scrutiny over mutual funds and the $10 billion plus of fees charged ($772.6 billion in assets @ 1.50%)?  

Investors know there are many ways to lose money. In looking at ETFs the risk of losing money can be broken into component parts.

Highest risk of losing money: costs

One never knows in advance what an investment’s return is going to be, but its cost is well known. Cost represents the greatest certainty of reducing capital for any product. Despite this obvious fact, it is stunning how many investors I’ve met have no real understanding of what they pay for products and services.

Some synthetic ETFs use swaps in their construction. In Canada these includes Horizon S&P/TSX 60 Index (HXT) and Horizons S&P 500 Index (HXS). Part of the cost of these products is the swap fee paid to counterparties to deliver the return of the underlying index. While the swap fee for HXT is listed as zero, interest and fees for securities lending likely provides the required margins. HXS bears a 0.30% fee. Investors should add this to the MER of 0.15%. The total expense ratio for HXT is 0.07%. These two ETFs offer a particular advantage for taxable investors by providing the total return of the underlying indices, the S&P/TSX 60 (HXT) and the S&P 500 (HXS). No taxable distributions are involved so capital compounds unfettered by tax.

Next highest risk of losing money: stupidity

Bet you thought this might be risk #1, but costs are certain. A stupid investor could actually get lucky once in a while!

Leveraged and inverse leveraged ETFs have been categorized as appropriate for daily trading only. This satisfies regulators and the compliance departments of brokerage firms even though the actual category should be “appropriate for daily trading only for dummies who won’t read the prospectus or bother to estimate volatility drag”. Otherwise intelligent people condemn these vehicles because compounding returns conceptually escapes them! Leveraged and inverse ETFs use synthetic structures although they are not listed in the table below. They form a subset of ETFs with embedded strategies. If you don’t understand a product, don’t buy it.

 Sometime risk of losing money: counterparty

Replicating an underlying index can be cumbersome. Some ETF sponsors choose to synthetically recreate performance. This involves posting collateral and having a counterparty (in Canada this means a bank) pledge the return. The quality of the counterparty and the liquidity and value of the collateral are the key points of concern for these ETFs. Synthetic structures involve fees that are classified as trading costs but should be considered as an overall cost of the structure.  

If one of the major banks fails as a counterparty, Canadians will have much more to worry about than just a synthetic ETF. Nevertheless, safeguards limit single counterparty exposure in Canada to 10%. In Europe, there is concern that ETF sponsors are using their own banks as counterparties. This has not happened in Canada yet. The risk of counterparty failure is difficult to assess. Just because it hasn’t happened here doesn’t mean it will never occur even if collateral in Canada is all cash. I learned from U.S. bond traders that some unquantifiable risks could be assessed as .05% on a trade. If one assumes that counterparty risk is 0.05% per annum, HXT’s actual-plus-notional cost would be 0.13% (0.08% TER plus 0.05% for counterparty risk). Over twenty years, the risk of a counterparty collapse with 100% cash collateral is 1.0%. This seems reasonable.

The table below shows all non-leveraged or inverse synthetic ETFs in Canada. Data is from a comprehensive report about ETF regulatory issues by National Bank Financial’s ETF team of Chiefalo, Straus and Zhang and is ranked by market value.

ETF Name	Symbol	MV ($M)	TER (%)	Structure
Horizon S&P/TSX 60 Index	HXT	$326	0.08	Swap
Claymore Advantaged High Yield Bond	CHB	$290	0.53	Forward
Claymore Global Monthly Advantaged Dividend	CYH	$128	0.67	Forward
Claymore Advantaged Canadian Bond Fund	CAB	$118	0.56	Forward
Claymore Natural Gas Commodity	GAS	$94	0.86	Forward
Claymore Broad Commodity	CBR	$45	0.90	Forward
Horizon COMEX Silver	HUZ	$18	1.28	Forward
Horizon Betapro S&P 500 VIX Short Term  Futures Bull+	HVU	$18	1.30	Forward
Horizon COMEX Gold	HUG	$15	1.28	Forward
Horizon S&P 500 Index	HXS	$11	0.45	Swap
Horizons Winter-term NYMEX Crude Oil	HUC	$4	1.28	Forward
Horizon Betapro S&P 500 VIX Short Term Futures	HUV	$2	0.90	Forward
Horizons Winter-term NYMEX Natural Gas	HUN	$1	1.28	Forward

 

Synthetic structures are making useful products available to retail investors in cost effective packages. If you don’t understand these products or don’t want to do the research, may I commend lottery tickets or mutual funds for your consideration? Synthetic-based ETFs require more scrutiny. A little research will reveal valuable new strategies and products to you but you can’t pick them by using your spouse’s birth date.   

Don't pick your nose with a power drill

Derivatives offer useful and cost-effective ways for investors to manage risks. In the ETF world, derivatives have democratized investor access to asset classes like commodities and currencies, and to strategies like covered-call writing, use of leverage and short selling. Previously the sole domain of professional and sophisticated investors, this freedom has come with the expected consequences of misuse and plain ignorant use of some or all of these products.

Three questions arise from the increasing use of synthetic structures in retail products.

1. Are the benefits and costs associated with these products adequately understood by users?
2. Are there potential systemic risks arising from the growing popularity of these instruments?
3. Who is best equipped to determine if investors should have access to these products: regulators, investment professionals, or investors themselves? Each will be examined in more detail over the next three months. Here is a broad overview.  

Overview: The right tool for the job

Having a plan is as basic to portfolio construction as it is in the workshop. What will the portfolio have to do? What characteristics must it have? Selecting the appropriate tools and materials and understanding the capabilities and inherent risks with each is simply common sense. While possible to drive a nail with a screwdriver, it isn’t always as effective as using a hammer. Selecting ETFs is no different.

Returns are difficult to predict, but costs are different. The ETF Screener on the TMX Money website offers two basic ETF classifications: those using passive strategies and those using embedded strategies and costs are behind each.

Passive

These are straightforward ETFs that replicate an index and hold the actual components or a stratified sampling of the index holdings. Examples:

PASSIVE	TICKER	MER
BMO Aggregate Bond	ZAG	0.50%
Claymore S&P/TSX Canadian Dividend	CDZ	0.60%
Claymore Gold Bullion	CGL	0.50%
iShares S&P/TSX 60 Index	XIU	0.17%
iShares S&P/TSX Capped Energy	XEG	0.55%
iShares S&P 500	XPS	0.24%
PowerShares Canadian Dividend Index	PDC	0.50%
PowerShares QQQ (CDN Hedged)	QQC	0.32%
PowerShares Ultra DLux Long Term Government Bond	PGL	0.25%
RBC 2013 Target Corporate Bond	RQA	0.30%
RBC 2014 Target Corporate Bond	RQB	0.30%
RBC 2020 Target Corporate Bond	RQH	0.30%

Embedded strategies

All other ETFs fall into this category, suggesting additional analysis may be required. We have broken these into three subsets with additional costs associated with each.

Strategic: Holding equal dollar amounts of index components is one example. Proponents claim reduced large capitalization company bias in an index allows smaller faster-growing companies to contribute equally. Whether or not you believe this (there is research supporting both sides), more frequent rebalancing incurs more trading costs. This holds true for so-called fundamentally weighted indexes and active ETFs. Investors must decide if the costs are justified by the strategy. Examples:

EMBEDDED STRATEGIES – STRATEGIC	TICKER	MER
BMO S&P/TSX Equal Weight Oil & Gas	ZEO	0.55%
Claymore Canadian Fundamental	CRQ	0.65%
Horizons Dividend	HAL	0.70%

Exchange-traded derivatives: These ETFs can involve options and futures and introduce time as a more critical investment factor. Covered-call ETFs, for example, alter risk over time; modestly for ETFs overwriting a small portion of underlying holdings (i.e. FXF) to those that overwrite all of the holdings (i.e. ZWB). Commodity ETFs can hold the underlying commodity, but many use futures. This subjects these ETFs to liquidity, basis, contango and backwardation risk. ETFs using exchange-traded derivatives introduce some elements of additional cost from liquidity, basis, timing (backwardation/contango) in addition to possibly higher management costs. Leveraged-long and leveraged-short ETFs also fall into this category.

Examples:

EMBEDDED STRATEGIES - EXCHANGE TRADED DERIVATIVES	TICKER	MER
BMO Covered Call Canadian Banks	ZWB	0.65%
Horizons S&P/TSX 60 Bull	HXU	1.15%
XTF Can 60 Covered Call	LXF	0.65%
XTF Can Financial Covered Call	FXF	0.65%
XTF Tech Giants Covered Call	TXF	0.65%

Over-the-counter derivatives: OTC derivatives are based upon total return swaps. A dealer commits to pay the return of an index over a particular time period in exchange for collateral. This introduces a potential cost as credit risk because the dealer or counterparty is promising to pay. It also introduces potential liquidity risk related to the collateral. Examples:

EMBEDDED STRATEGIES -OVER-THE-COUNTER DERIVATIVES	TICKER	MER
Horizons S&P/TSX 60 Index (swap fee 0.0%)	HXT	0.07%
Horizons S&P 500 (swap fee 0.30%)	HXS	0.15%

Investors and their advisors have a duty to understanding the risks inherent in these products and their potential impact on broader markets. Do regulators know better than advisors or their clients whether these products have a place in retail portfolios? We’ll address these issues in future columns.