When ETFs Get Dangerous

StockMarketBoardWhen Exchange Traded Funds or ETFs were first conceived, they were intended to be simple for investors to understand. They were designed to track an index in the same way that a mutual fund would but with one difference – they traded on a stock exchange like a share. This made it easier for investors to buy and sell their investment any time during the day.

Nothing could have been simpler. Or so we thought.

That’s because somewhere along the way, someone decided to make them more complicated than necessary. In fact, some ETFs have become so complex that John Bogle, the founder of Vanguard, warned that buying those ETFs was akin to owning a Purdey shotgun. He said the firearm was great for big-game hunting in Africa but also excellent for suicide.

Truth is ETFs were meant to be an elegant investing tool for investors looking for a low-cost way to get broad diversification and, perhaps, gain exposure to markets that may not be easily accessible. But as ETFs evolved, new entrants started to distinguish themselves in different ways.

Some providers developed leveraged ETF, which meant that if an index rose 1%, the fund would rise by some multiple of the increase. Some providers developed inverse ETFs. These products, which were not available in regular mutual funds, would fall if an index rose and rise if an index fell.

This was the moment when ETFs started to get a little dangerous.

Some banks started to develop synthetic ETFs that on the surface appeared like a traditional ETF but wasn’t when you took a closer look. They may use derivatives such as swaps in which one bank might borrow from another in exchange for, say, the return of the Dow Jones Industrial Index, the FTSE All-Share index or some other index. The upshot is that investors in these ETFs may unwittingly be exposing themselves to counterparty risk.

So as ETF companies continue to churn out new and exciting ways to access diverse areas of the market, it’s imperative that we be vigilant.

As an aside, I would never buy a car without looking under the bonnet or kicking tyres. That’s because I know a little research can save expensive repair bills down the road should the wheels ever fall off. And I would never buy an ETF unless I am comfortable with the way it tracks the underlying investment.