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.