Focus on: Exchange Traded Funds

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06/11/2018
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Exchange Traded Funds (ETFs) are often touted as a safe and favoured investment of every passive investor. After all, they simply track the performance of an index, currency or commodity. Their popularity has steadily grown worldwide since the early nineties and are favoured amongst investors because they are low cost, tax efficient and trade in a similar manner to companies listed on a stock exchange.

A FTSE 100 ETF for example will simply track the FTSE 100. It will replicate the performance of the FTSE 100 by investing in the same companies that make up the index and in the same weightings. This is known as physical replication, and in general will perform in line with the FTSE 100.

ETFs can also offer diversification in any portfolio for those seeking alternative investment strategies. The ability to invest in lean hogs (pork), coffee, soybeans, oil and direct currency can provide a real alternative investment strategy. ETFs can also be used for hedging purposes; for example, if you have a portfolio of FTSE 100 shares, then you may want to hedge against a market fall and invest in an ETF that goes up in value should the FTSE 100 fall in value. This is known as going short. Investors are also able to invest in leveraged ETFs which can enhance returns, and losses. Unlike the aforementioned 
‘physical’ ETFs, these are known as ‘synthetic’ ETFs. This is because instead of owning the underlying assets, they will simply be exposed to their price movements using derivatives.

However, like all investments there are risks associated with investing in ETFs. You might not be familiar with the name Kweku Adoboli, but he was the rogue trader that cost UBS over £2 billion in 2012, dwarfing the losses incurred by the more famous rogue trader, Nick Leeson, who bought about the collapse of Barings bank. The trades were the largest unauthorised trading losses in British corporate history. Kweku, disguised the risk of his trades by using forward-settling ETF cash positions. Although the full details of these trades are unknown, it is likely that it involved heavily leveraged ETFs.

Investors need to be wary of leveraged ETFs, as these are generally only suitable for sophisticated investors. There tends to be confusion on the rebalancing process on these instruments. However, many of these types of ETFs will tend to have ‘daily’ in the name, as the only suitable holding period for this instrument is one day.

For example, an investor may decide to go short on the FTSE 100 and may desire leverage up to 3 times the movement of the index. This means should the FTSE 100 increase 5% in one day the value of your position would decrease by 15%, so an investment of £1,000 would now be worth 
£850. Should the FTSE 100 go down by 5% the following day then the return would be 15% of 
£850 and so your position would be £977.50. So,  an equal movement in an index over a period can result in a loss. A volatile market will erode returns over the long term.

This can be illustrated in the graph on the next page. You can see the return offered by two FTSE X3 leveraged ETFs (one short and one long)  when compared to the performance of the FTSE 100. The long ETF has only marginally outperformed the FTSE 100, this is despite being highly leveraged. Over the period, the short ETF has lost almost 80% of its value, so a £1,000 investment would now be worth £244. Even if the FTSE 100 were to fall back to 0% growth over the period, then the original investment in the short ETF would only be worth £498. A loss of 50% on the original investment.

 

graph

 

As this illustrates, there are considerable risks when investing in some types of ETFs. However, there are other benefits; namely avoiding company specific risk. Take BP for example, whereby mostly all its revenues are derived from the drilling and subsequent sale of Brent Crude in the energy market. Nevertheless, company performance and the commodity on which it is so heavily reliant don’t always go hand in hand as the graph below illustrates. As you will note, the time period in question is a 
four-year period between the start of 2010 and the end of 2013, whereby the commodity outperformed BP by almost 50%. Many people will remember the Deepwater Horizon oil spill in 2010 which subsequently led to a very difficult time for BP, however, the price of Brent crude remined unaffected  by the spill.

 

graph 2

 

So, those that want exposure to oil without wanting to be exposed to company specific risk, ETFs offer the perfect solution. Furthermore, if it wasn’t for ETFs then the only way of gaining exposure to commodities such as lean hogs would be to buy them and store them at home, and I’m sure your neighbours would have something to say if you tried to store a parcel of hogs at home!

It should be noted that many ETFs are domiciled outside the UK, and therefore they are not covered by the UK’s Financial Services Compensation Scheme. In addition, during the days following the collapse of Lehman Brothers, some ETFs were suspended from trading as Lehman’s was involved in their market making. It also became very difficult to replicate some indexes whilst liquidity was so distorted. Very rare circumstances, but nothing is ever risk-free.

 

 

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The value of an investment with Rowan Dartington may fall as well as rise. You may get back less than the amount invested.