ETFs rely on a market index for the development of an investment strategy and standard of performance. The standard of performance is measured as an annual percentage change in index value. The ETF investment goal is a statement of the desired performance of the fund’s portfolio relative to the performance of the market index. Investment strategy is the fund’s stated plan for achieving its investment goal. Most ETFs use the investment strategy of physical replication.
Physical replication (passive management)
Most ETFs are index funds that seek to match the performance of a securities market index by the process of passive management. Passive management attempts to earn a return equal to the index performance, less fund expenses, by investing in equities or bonds. Tracking error is used to grade how closely the fund matches its index. The ideal tracking error is 0, but an acceptable tracking error is 0.25%/year. One risk of index funds is the volatility of share prices in parallel with fluctuations of the market index1,2.
Physical replication involves SECURITY REPLICATION or SECURITY SAMPLING of the market index.
- SECURITY REPLICATION is used to acquire every security listed in the market index in proportion to a weighting factor3. The fund’s tracking error is expected to be minimal.
- SECURITY SAMPLING does not acquire every security listed in the market index; instead, managers choose a representative sample of the market index. Sampling is used when thousands of different securities in the index (some of which are likely illiquid) make replication impractical if not impossible. Managers must adjust the sampling process to minimize tracking error2,3.
DERIVATIVE REPLICATION (‘synthetic’ replication) involves investing in derivatives to match the performance of a commodities index. Managers of synthetic ETFs use a proprietary model to invest in futures, asset swaps, options, and other derivatives. Beware of synthetic ETFs (called ETNs) that purchase contracts or notes which guarantee payment of the total return of an index from a counterparty bank. The bank supplies collateral that might be illiquid assets unrelated to the investment goal of the fund. The documents of the synthetic ETF should disclose this strategy and the type of collateral supplied by the counterparty bank. DERIVATIVE REPLICATION incurs the risks of counterparty default and acquisition of illiquid collateral assets1,4,5,7.
The INVERSE STRATEGY seeks the opposite performance of a market index. For example, the successful inverse fund achieves a 10% increase in value when its market index declines by 10%, or a 10% decrease in value when the index rises by 10%4. Purchasing an inverse index fund can yield profits from a declining market by shorting the market or buying derivatives. Shorting the market means to sell borrowed stocks and repurchase them later at a lower price. The profit is the price difference between sale and purchase2.
The LEVERAGE STRATEGY uses debt to increase investment performance. Leveraged ETFs (so-called geared funds) seek to multiply the performance of a market index by a stated numerical factor. For example, the successful 2X leveraged fund achieves a 20% increase in value when its index increases by 10%. Likewise, the 2X leveraged-inverse fund seeks a 20% increase in value when its index decreases by 10%. The borrowed money is used to buy financial assets in anticipation that the return from purchased assets exceeds the cost of the loan. Otherwise, the fund will underperform the market. The best case for a leveraged fund is when interest rates decline (i.e., lower cost of borrowing) and the stock market rises (i.e., higher return). The worst case for a leveraged fund is when the stock market declines and interest rates rise. The fund manager of a leveraged-inverse fund borrows money to purchase extra assets when the market is declining2.
Leveraged funds are risky and leveraged-inverse funds are extremely risky2,4,6,7 for two reasons: 1) the investor risks a magnified loss. 2) Leveraged ETFs are designed for day trading, not for longer holding periods. The risk of a compounding loss increases with holding a leveraged ETF beyond one day.
Only a few ETFs (e.g., some bond funds) seek to outperform the market index by process of ACTIVE MANAGEMENT. The active manager neither replicates nor samples an index to match its performance, but instead creates a unique mix of investments to satisfy the investment objective8. The risk of ACTIVE MANAGEMENT is a failure to outperform the market based on inherent inability to accurately predict the future. Poor predictions and selections of assets lead to under-performance of the market2.
Copyright © 2012 Douglas R. Knight
1. BIS Working Papers No 343: Market structures and systemic risks of Exchange-traded funds. Srichander Ramaswamy, Monetary and Economic Department of the Bank for International Settlements, April, 2011. http://www.bis.org/publ/work343.pdf
2. All About Index Funds, second edition. Richard A. Ferri, CFA. McGraw Hill, 2007
3. Investment Company Factbook, 50th Edition, A Review of Trends and Activity in the Investment Company Industry. Investment Company Institute, 2010.
4. Potential financial stability issues arising from recent trends in Exchange-Traded Funds (ETFs). Financial Stability Board, 12 April 2011. http://www.financialstabilityboard.org/publications/r_110412b.pdf
5. Exchange-traded funds: A good idea in danger of going bad. The reckless expansion of “synthetic” funds requires a few new rules, June 23rd 2011, The Economist. http://www.economist.com/node/18867037?story_id=18867037
6. SEC Looks Into Effect of ETFs on Market, Scott Patterson, Wall Street Journal, September 7, 2011. http://online.wsj.com/article/SB10001424053111903648204576554770203689108.html?mod=ITP_moneyandinvesting_0
7. Exchange-Traded Funds: Too much of a good thing. The risks created by complicating a simple idea, June 23rd 2011, The Economist. http://www.economist.com/node/18864254 .
8. 2012 Investment Company Factbook, 52nd Edition. Investment Company Institute, 2012. http://www.icifactbook.org/2012_factbook.pdf