ETFs: The good, the bad and the ugly

PORTFOLIO POINT: It’s a huge and fast-moving market, but our study of ETFs finds investors can’t always be sure about what they’ve bought.

The exchange-traded fund market and those who trade them have been put on notice as regulators around the world scramble to impose new fiduciary requirements on players in the fast-moving $1.7 trillion market.

Meanwhile, a string of warnings from ASIC and carefully worded statements from its chairman Greg Medcraft over recent weeks have inspired Eureka Report to conduct a comprehensive review of the sector in Australia.

The warnings have centred on three areas: transparent pricing of the securities; the ease with which investors can make transactions; and exposure to derivatives. Individually, any one of these issues is a cause for concern when left unchecked. Combined they have the potential to leave investors sitting on serious losses.

When asked on radio about ETF pricing, Medcraft said the issue is “very important, particularly when somebody is investing in an ETF which is referenced on a foreign index, because often we've found the gap in risk can be as much as 20% between the closing price and the opening price in Australia”.

This acknowledgment is likely to be cold comfort for Australian investors who know that overnight markets set the tone and frequently make transactions at the beginning of the day. Further, we can reveal that the market makers – those employed by ETF issuers to ensure the securities are liquid – are only required to maintain prices 80% of any six-hour session.

In a separate statement on derivative exposure, Medcraft went even further when he alluded to issues first raised by Eureka Report back in 2010 (click here) when he said: “ASIC is monitoring this area closely and will review thoroughly the introduction of any new types of ETFs in Australia, as some of these can be complex investments that may not be suitable for many retail investors.”

For readers keen to achieve equity market exposure but avoid the expenses and underwhelming performance of traditional managed funds through ETFs, the issues raised are worth exploring in some detail.

First, let’s look at the background.

What types of ETFs are available in Australia?

State Street pioneered ETFs in Australia with the launch a decade ago of its flagship ETF over the S&P/ASX 200 index, ASX code STW. This is an example of a traditional “passive” or “vanilla” ETF – where the ETF unit represents a claim over a basket of physical shares that match the composition of the underlying index or asset. More recently, ETFs have been issued in Australia that provide exposure to sub-indices, or sectors such as the ASX resources or financial indices – these also represent a claim over a basket of physical shares comprising the index.

Since then other less transparent varieties have emerged including:

• “Strategy” ETFs, where the issuer creates a bespoke index to deliver a specific style of investment return (such as the Russell “Value” ETF, ASX code RVL), and where the ETF then tracks that index by holding the shares which are contained in the index. Strategy ETFs are sometimes known as “semi-passive” since the index itself changes composition in line with the style it is designed to implement.
• “Synthetic” ETFs, where the exposure to the underlying index is managed by combining physical shares with a derivative overlay, which is designed to ensure that the tracking error between the ETF and the underlying index is minimised. (ASIC has focused on these new synthetic ETFs to limit the derivative exposure to less than 10% of the value of the ETF, and to require identification of the derivative counterparty in the product offering document).
• International or Commodity ETFs, where the ASX-listed ETF invests in turn into ETFs listed on overseas stock exchanges, to provide exposure to international markets or commodities.

Most investors would be aware that ETFs buy shares that are constituents of an index the ETF is designed to “track”. What most investors don’t realise is how often the price of ETFs diverge from the underlying asset or index that they are supposed to track.

This is the primary issue that investors need to pay particular attention to and since ETFs pride themselves on being more transparent than many traditional managed funds, we asked the current suite of ETF providers on the ASX to tell us how closely the ETFs’ NAV correlate with the underlying index and secondly how closely does the ETF traded price correlate with the ETF net asset value?

Although this sounds complex it’s worth understanding because it essentially boils down to investors getting what they paid for.

Of the six ETF providers surveyed only four were prepared to furnish Eureka Report with the data I required: BlackRock Investments, Russell Investments, State Street and BetaShares. At the time of writing, Vanguard and Australian Index Investments had not responded to our survey.

ETF pricing

As already mentioned, perhaps the key issue for investors is the correlation between the ETF and underlying index/asset price. Our survey shows a fairly high degree of correlation between underlying asset and ETF prices, in many cases well above a 99% correlation. Newer ETFs, especially offering exposure to less liquid stocks/sectors, show higher “tracking error” between their net asset value and the underlying index level and therefore creating the potential for investors to be short-changed.

Data provided by iShares showed a small degree of variation with the NAVs of its ETFs showing correlation of between 97.5% and 98.4% with the underlying index. But when it came to the correlation of the prices of the ETF and the NAV the gaps were larger, with a correlation of 85.2% for its strategy-based security – the S&P ASX High Dividend ETF (IHD) – and upwards of 93% correlation with the remaining index based ETFs.

StateStreet has been issuing ETFs in Australia for a decade and has strong data for the period, showing very high correlations – at least for its large-cap funds. The flagship S&P/ASX 200 ETF (STW) has a historical correlation of 99.94% between ETF NAV and index levels. Their other large-cap ETFs track in the range of 99.92% to 99.87%, with newer sectoral or thematic ETFs tracking between 99.5% and 99.8%.

Russell Investments responded to our survey with equally detailed data that shows how its ETFs track closely with underlying indices and net asset values. When it came to the correlation between the NAV of Russell’s ETFs and the underlying asset, Russell’s ETFs scored well, with the Russell High Dividend ETF (RDV) having a correlation of 97%. Russell strongly encouraged investors to check the iNav of their ETFs prior to buying or selling. It’s worth noting that the Russell Australian Value ETF (RVL) ETF had the lowest spread of the strategy-based ETFs and one that was competitive with the more easily maintained index based ETFs.

When it came to the provider with the strongest correlation, there was really no contest. The range of currency and commodity-based ETFs from BetaShares showed correlations of 99.9% and upward. As to what sort of correlation an individual investor should find acceptable, I would suggest that in most cases investors could be comfortable with anything around 97% or better.

Ease of transactions

The ASX manages the market makers for ETFs – who are responsible for ensuring a liquid market. Current market makers for ASX ETFs include Citigroup, Deutsche Bank, UBS, as well as such lesser-known names as Susquehanna Pacific, Optiver, and IMC Pacific (investors should check with issuers to see which market makers are active in specific ETFs).

To be eligible to be a market maker under ASX rules, the market maker needs to agree to provide two way prices (“bids” and “offers”) continuously during the day, with a preset “spread” between the bid and offer that allows them to make a profit and is the incentive for providing the service.

But the ASX rules give a couple of “outs” to market makers, and it’s these that seem to concern ASIC. Even though the general ASX market opens at 10am – because many stocks and ASX listed products don’t commence trading until sometime after that – investors can’t buy and sell ETFs immediately after 10am – and even then market makers are only obliged to show prices 80% of the time (click here), beginning at 10.15am each day.

The requirement for market makers only to be active 80% of the time during each day is a balance that recognises the far higher costs and risks that would be imposed if prices were required to be quoted constantly during the trading day. For some investors, that may not be good enough. Having said that, our survey of ETF providers show a fairly uniform frequency of prices being refreshed by market makers constantly throughout the day.

What about international and commodity based ETFs?

Some ETF issuers provide access via the ASX, to ETFs listed on international exchanges. iShares is the most prolific provider of ASX ETFs that reference offshore indices. ASIC has pointed out that some securities will be more thinly traded than their international counterparts, producing what may ultimately produce unfavourable prices for local investors.

iShares pointed out that the ASX market makers for their global ETFs were able to hedge themselves either by trading in those global ETFs (where the offshore market is open during ASX trading hours) or by hedging using liquid instruments like futures contracts over the underlying indices where these are not open during ASX trading hours.

Global ETF providers point to the orderly functioning of ASX-listed ETFs providing exposure to the Japanese stockmarket during the recent Tsunami crisis – where ASX ETFs continued to trade in close correlation to the Japanese index even though it fell sharply during the crisis. Although there were some anomalies reported in some markets, such as London and the US, for the most part these were boutique funds with weak market makers and therefore not especially relevant to Australian investors.

From my research on commodity-based ETFs, I did not uncover any issues pertaining to pricing; indeed the BetaShares Hedged Gold ETF delivered especially high correlation between price and NAV, but that does not mean ASIC has given it the all-clear. Last week ASIC spelled out some of the risks particular to ETFs on its Money Smart website.

ASIC’s concerns about commodity ETFs were centred on those that chose to buy exposure through futures contracts rather than the physical commodity itself, for whatever reason. This means that not only will the ETF deviate from the current value of the actual asset but that more costs are incurred as futures contracts expire and need to be replaced new ones, which are potentially more expensive.

A report from Bloomberg last year revealed startling claims that institutions were bidding up futures contracts in the lead up to the monthly roll of futures contracts by commodity-based ETFs, only to see the value of those contracts drop almost immediately after purchase in a strategy known as “pre-rolling”. Although there is no evidence of this in Australia, it should give potential investors a good reason to thoroughly investigate the PDS of any commodity based ETF they are considering.

The return of counter-party risk

Since the global financial crisis most investors have learnt to be suspicious of derivatives and their potential to hurt your portfolio. In this regard it is helpful to know that ASIC requires all ETFs that use derivatives to put the word “synthetic” in the title.

Because the holding of derivatives creates “counter-party risk” – the risk that the party on the other side of the transaction does not fulfil their contract – they limit the aggregate money owing under derivatives to 10% of the ETF’s net asset value. ASIC has flagged that in the future that collateral for such arrangements be made up of assets such as cash to increase liquidity.

Yesterday Hong Kong regulators one-upped their European counterparts in a quest for transparency by requiring fund providers of synthetic ETFs to increase their holdings of collateral to 100% or more of its counter-party risk in an effort to strengthen protections afforded to its investors, a sign of things to come.

Related concerns include the need to have proper disclosure of the exact name and details of the derivatives counterparty in the PDS, and also detail regarding early maturity and similar events that can allow the derivative counterparty to terminate its contract.

Since these are most likely to be triggered in times of market disruption, it’s important that synthetic ETFs are carefully designed to robustly address the points, and that these details are clearly disclosed. Current synthetic ETF issuers such as BetaShares do provide an open and transparent approach to these issues; ASIC is no doubt concerned to ensure that new synthetic ETF providers take similarly high levels of care in relation to these points.

What should investors be looking for?

A number of ETF issuers responded to our survey by also noting that, in some ETFs that may not trade constantly during the day, the “last traded price” many online brokers display may not still be accurately tracking the changes in the net asset value of the ETF, thus delivering investors “stale” prices. Both State Street and Russell pointed out that investors can easily check these by getting a price for the “iNav” at the time of day they wish to complete a trade.

The iNav is the “indicative net asset value” and is the intraday measure of per share value of an ETF based on the basket of holdings that is published daily. It is a more accurate reference point to compare the available quoted prices at that time and provides an indicative value. This tool also enables investors to understand the size of the spread that they are also likely to experience at this time. If large, the product issuer or market maker can be contacted directly to see if there is a sufficient reason or whether the spreads can be decreased.

The iNav is easily accessible to investors through an online broking account, or even websites such as Google Finance. By simply including Y in front of the ticker (eg. YRDV, or YSTW) an investor can easily compare the indicative value for the index to the price being quoted for the ETF to ensure they are getting an appropriate price with competitive spreads at any point during the market open period.

Key points for investors

ASIC is to be applauded for its focus on investor protection. By pointing out that buying some ETFs at “stale” prices can be risky, and by raising awareness of some of the issues that investors need to understand when they buy or sell ETFs, ASIC hopefully has helped prevent uninformed investors from losing their hard-earned money.

At the same time, our survey has elicited a very high level of cogent and relevant information about the deep systems and processes offered by most ETF providers in Australia. Interested investors should research the data relevant to specific ETF issuers before investing – and this information is readily available from issuers and also from the ASX website.

The jury is definitely still out on the issue of whether Australian investors should be restricted from buying some types of financial products because they are unable to be explained in their PDS, in clear and simple language.

It is to be wondered whether traditional managed funds with their opaque investment systems, and often observed under-performance compared to their stated benchmarks, would pose similar concerns for ASIC if they were being introduced as a new concept today. There is a strong case for the argument that lower-cost investments that seek to deliver a defined investment outcome should be encouraged by our regulators. But by all means, let’s have that debate.

Tony Rumble is the founder of LPAC Online, which provides education to financial advisers on ASX-listed products.