December 18th, 2017

ETFs - Still a great financial innovation

By Andrew Craig

Reading time: ~ 5 minutes

Responding to your questions on ETFs

I have had a few questions recently about ETFs or Exchange Traded Funds (if you would like a reminder of what these are, I have written on the subject before in my book).

One person in particular got in touch to ask me if ETFs are “a ticking time bomb”. Given our fund is made up of ETFs, I felt that this was quite an important question to address head on and worth sharing my answer with the wider Plain English Finance readership.

So here goes…

In considering whether ETFs are problematic, it is important to make the point that there are ETFs, and there are ETFs. One of the key differences is that some are called “synthetic” or “swap-based” ETFs, whereas others are what is known as “physical” ETFs.

To explain

  • A “physical” ETF will actually own the underlying asset. If you put £10,000 into a physical gold ETF, they will own £10,000 worth of actual allocated gold bars to underpin your position. Or, for e.g., – if you put £100,000 into a “physical” S&P 500 ETF, the ETF provider will actually own shares in those 500 companies (Vanguard – the biggest S&P 500 ETF provider, who we use, does this and owns something like 7% of the S&P 500 shares as a result). (NB - For the avoidance of doubt, in the above examples you would end up owning that amount of the underlying assets minus the costs of ownership).
  • “Synthetic” or “swap-based” ETFs are products where the ETF provider is basically selling you a derivative or "bet" on whatever it is that they’re trying to replicate for you. This is potentially problematic, primarily because you’re relying on the balance sheet of that entity and not actually ending up owning the underlying assets. That said, 99.9% of the time, providers of such products trade perfectly normally. It is only under extreme circumstances (e.g. a large company going bankrupt), that you might worry about such a product.

Bearing the above in mind, wherever possible, we own physical ETFs. This means that 21 of the 24 underlying funds we use to "own the world" are physical. Only our agriculture, energy and industrial metals funds are synthetic ones and this is due to the very nature of those investments as they are based on derivative contracts to begin with (e.g. agricultural futures).

I would suggest that any concern about ETFs that you might read about in the press will come from one of two sources:

  1. First - concern about potential problems brewing with synthetic ETFs – as discussed above. Here we have limited exposure via our three synthetic ETFs as I have explained. It is also worth noting that the company providing these three funds, ETF Securities, has many billions of assets under management and a long track record in the space. There are certainly examples of large companies such as them going bust (Lehman Brothers and MF Global are two high profile examples) - but each of the ETF Securities funds are separate legal entities with the Bank of NY Mellon as custodian, Law Debenture Trust as Trustee and Merrill Lynch and Citigroup as market counterparts. Taken together, this gives me a reasonable degree of comfort that any counterpart risk for these three funds should be limited.
  2. Secondly – concern that trillions have flowed into passive / ETF products generally and this constitutes a “massive bubble” which could unwind. This point, I think, is rather misleading and something of a red herring.
    There have been massive inflows into ETFs as a new generation of investor has seen the merit in using inexpensive passives vs. “expensive” (and often underperforming) active funds. I have written about this before in my article, 'ZIRP, Inflation, QE and Other Animals.'

This has meant that vast sums of money have flowed into passive trackers of markets all over the world. There is a chance that this money will flow out of those markets. I would argue that this is no different to at any other time in history as an investor. Perhaps folk have been less discriminating as a result of all this passive money (which is why the largest companies like Apple, Alphabet / Google and so on have exploded upwards in something of a self-fulfilling circular upwards spiral and – yes – this could go into reverse in a crash – into a downward spiral) – but it was ever thus.

The point is, that if a crash comes (and our trend following tells us that it is time to sell a market – e.g UK equities or US equities), I would rather own a massive, liquid ETF which I can sell in a heart-beat in large quantities than the majority of the underlying companies in that ETF – which are more likely to see liquidity constraints.

In the largest crashes in history, the market as a whole might in extremis fall 10% (or 20% on one occasion in 1987). Some of the component stocks of the index, however, will fall a great deal more than that or there might be no buyer at all.

As such – In my considered opinion, I have a good measure of comfort that the ETFs we use should not be any kind of ‘time bomb’ – any more than equities / markets are more generally – in which case our diversification and use of trend following means we will quite likely be out and parked in cash anyway. As a reminder, the model we are using would have been nearly 90% in cash by the end of 2008 - the last time there was a big market crash. (You can see the evidence for this on page 14 of our Fund Overview document.

Remember too that we have no more than 6% of the fund in any one of our market ETFs at any time (we will sometimes have more than 6% in some of our cash or "risk free" ETFs).

And finally...
It is, perhaps, worth pointing out that choosing which ETFs we use to own the various investment silos and monitoring them on an ongoing basis is a key part of what we are doing as managers of the Plain English Finance fund. As an example, we have just swapped our emerging markets Eastern Europe and Latin America equity funds for two larger, more liquid equivalents as the ones we originally used became rather small and then de-listed. I think this demonstrates how robust the approach is. We didn’t have to skip a beat and were able to simply swap one ETF for another one to achieve essentially the same exposure, with no detrimental impact on the fund. The precise details of which funds we switched from and to will be detailed in our next quarterly Fund Update, in January.