ETF investing risks

Exchange-traded funds were created for institutional investors as a way to easily and cheaply track an index. But what started as a simple product has evolved into a no holds barred arena, and retail buyers are caught in the middle.

While many Canadians are happy to own simple ETFs that track major indices, such as the S&P/TSX Composite Index, many would be surprised to learn that they’re not always getting the plain ETFs they expect. At the same time, investors are being enticed by complicated products with the potential for higher returns through leverage and access to niche markets that only industry experts can understand.

It’s a worrying trend, says John Gabriel, an ETF strategist at Morningstar in Chicago. “They started off as a plain vanilla, low-cost index tracker, but now anything with the ETF moniker gets lumped in together.”

Gabriel’s especially concerned about the way ETFs use leverage and inverse strategies. Leverage products use complex financial instruments, such as derivatives and debt, to boost returns. While this strategy magnifies the potential upside, it also amplifies the possible downside.

Inverse ETFs, on the other hand, essentially short the market. While that could be useful in a bear market, it’s still a complicated product that uses derivatives, such as futures, to achieve results.

A real concern with leverage and inverse products is that they reset every day. While an inverse product will go up if the market falls, the return is calculated on a daily basis, not over a long period of time as it would be with a standard ETF.

Here’s an example from Vanguard’s website: Say you bought a 2x-leveraged ETF for $100 a share and the index is at 10,000 that day. If the index rises 10% to 11,000 your principal will increase by $20 to $120. The next day the index drops back to 10,000. You might think that your returns should be flat—the index went up 10% one day and fell 10% the next—but really, the index has declined 9.09%. On a daily resetting leveraged ETF, that means you lost 18.18% or $21.82. Although the index is flat over two days, your principal has now fallen to $98.18.

The trouble is leverage and inverse strategies were once left in the hands of institutional and registered investors who can afford the extra risk. Even today, if you want to use any of these strategies on your own you’d need to have a margin account, get approval from a broker and sign risk disclosures. But new ETFs do away with all of that.

“These investors didn’t have access to complicated strategies before,” says Pauline Shum, a professor of finance at Toronto’s Schulich School of Business. “Now people can trade them online without knowing how these structures work.”

Even if an investor doesn’t want to take a chance on risky ETFs, some may end up accidentally owning them, says Shum. “You often can’t tell what the product is from the name alone.”

For instance, if investors want to get access to the S&P/TSX 60, they can buy the iShares S&P/TSX 60 Index Fund (XIU) or the Horizons S&P/TSX 60 Index ETF (HXT). While they may sound like they do the same thing, there’s one big difference; while the iShares product owns shares in the companies on the index, the Horizons product replicates the index using a total return swap, which involves entering into deals with a counterparty.

These swap-based investments are called synthetic ETFs and they’re usually riskier than buying a straight index-tracking product, says Shum. If someone buys the synthetic ETF instead of the more traditional one, they could wind up with a much different return than they expected.

Investors need to read their ETFs prospectus before buying, she says. The document should explain how the product is structured, what type of investments it holds, its compound annual returns and how often the ETF rebalances.

ETFs that trade commodity futures have also been popular with retail market, but few investors understand how they work. One risk with this type of ETF involves something called roll yield. If the futures price is higher than next month’s spot price—the futures in these products usually roll over monthly—the ETF can lose money even if the price of the underlying commodity doesn’t change.

Gabriel says the majority of investors should stick to the basics—a plain, boring product that tracks an index like the S&P 500. “Investors need to know what they own,” he says. “If you don’t understand the futures market, don’t buy a commodity ETF.”

Unfortunately, the trend within the ETF industry is to create more hard-to-understand products. “Anyone can come up with one,” says Shum. “The industry is moving way too quickly.”